S&P's French Kiss

France deserves a downgrade at least as much as the United States.

You probably heard that on Aug. 5 Standard & Poor's downgraded the United States one notch, from AAA to AA+ *. You may not have heard that on Aug. 10 S&P said France's current AAA rating was "warranted" and "stable." S&P was saying that the United States is a bigger credit risk than France.

The market is behaving as though S&P had said the exact opposite. Treasuries rose in price, and the United States.was able to auction $72 billion of notes and bonds at 2.13 percent, the lowest average yield for a re-funding on record. Meanwhile, the difference between French and German yields on 10-year bonds rose to almost a full percentage point. That's the largest spread for France since the euro was established. The annual cost of insuring French debt against default for five years soared from about $75,000 in the earlier part of the summer to $175,000, compared with about $55,000 to insure the United States. (The cost of insuring French debt has since fallen back to about $150,000.) The market is saying that AAA France is a much bigger credit risk than the AA+ United States.

Qu'est-ce qui se passe?

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One view of the market's reaction is that the downgrade of the U.S. raised fears that S&P would downgrade France, despite the agency's reassurances. Another (not necessarily contradictory) view is that the market has zero respect for S&P's judgment about the relative creditworthiness of the two countries. When I asked investors whether S&P's response made any sense, the reaction was uniform: Of course it doesn't!

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Investors really don't have any respect for the agency's reasoning in downgrading the United States. The first thing S&P cited in announcing the downgrade was "political risks": its belief that "the effectiveness, stability and predictability of American policymaking and political institutions have weakened." To be sure, S&P also talked about the U.S.'s soaring debt-to-GDP ratio—a key quantitative measure of a country's financial health—but its concern was less about the number than about the possibility that we won't be able to tame the growth of our debt. The widespread feeling among most investors I spoke to was that regardless of whether S&P was right or wrong, it wasn't appropriate for the ratings agency to make so political a judgment. Nor, they said, was politics anything about which S&P has previously demonstrated any particular expertise. (You could even ask whether S&P has demonstrated any expertise about the Eurozone, given that the agency rated Ireland and Spain AAA in 2006.)

Based on many purely quantitative measures, France is actually in worse shape than the United States. John Chambers, the chairman of S&P's sovereign ratings committee, conceded the point in an Aug. 8 conference call. France's debt-to-GDP levels aren't significantly different from ours. Indeed, S&P has forecast that in 2015, France's debt will be 83 percent of GDP, higher than the 79 percent that it forecasts for the United States. But S&P thinks France has demonstrated a greater willingness to tackle its problems—for instance, by reforming its pension system—and that France's ratio will come down dans les annéessuivantes , whereas ours will increase. Maybe S&P is right, but there's enormous weight resting on that qualitative judgment, because France has several disadvantages relative to the United States. It will likely face more difficulty growing its way out of its debt problem because France's gross domestic product is growing even more slowly than ours is. (France logged a 0.9 percent increase during the first quarter and no increase at all during the second.) And France's currency, the euro, is not the reserve currency of the world, as the U.S.'s is. That status, according to Moody's, give the United States "unmatched access to financing."

In addition, there's this little matter of Europe being in the middle of a rather dire financial crisis. No one I spoke to thinks that you can view France's credit as being independent of the Eurozone. France has contingent liabilities to the European Financial Stability Fund, which is Europe's attempt at a bailout mechanism, meaning that France is partly on the hook for the EFSF's existing loans and may have to cough up more. One market observer told me that including those liabilities increases France's debt to GDP ratio by almost one-third.

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Also, French banks are on the hook for loans they've made directly to weaker European countries. Sean Egan, the president of independent rating agency Egan Jones, says that French banks' exposure to Greece, Ireland, Portugal, and Spain totaled $83.1 billion, $77.3 billion, $48.5 billion and $201.3 billion, respectively, as of the end of last year. French banks' exposure to flailing European nations is an issue for the credit standing of France itself, because in the modern financial system you can't logically separate any country's government from its banks. (Iceland, which allowed its banks to default on their loans to foreign creditors, has been the exception.) "The method the authorities rightly chose three years ago was to substitute the credit of the state for the credit in the financial system," the hedge-fund wizard George Soros told Der Spiegel on Aug. 15. Once you do that, you can't go back. Or as Mark Blyth, a professor of international political economy at Brown *, put it to me: "Banks used to bail sovereigns. Now, sovereigns bail banks!"

France's potential liability is a big part of the reason why Egan Jones, unlike S&P, rates France below the United States. Egan Jones downgraded the U.S. to AA+ on July 16—almost a month before S&P did—but the firm rates France a AA-minus, several notches lower. In calculating its rating, Egan Jones figures in the underfunding of a country's banking system: "We use a base assumption that no country can afford to allow its major banks to fail." Egan estimates that France's top 10 banks are undercapitalized by $343 billion. (Egan calculates the undercapitalization by taking 8 percent of a bank's listed assets, which is the percentage of assets that a bank should hold in equity, and subtracting from that the market value of the stock. That provides a metric for how undercapitalized the market thinks a given bank is.) Instead of basing its debt-to-GDP calculations on net debt, Egan bases them on gross debt. Egan believes that any attempt to estimate the value of a country's assets will be too fraught with uncertainty, and the assets themselves too hard to realize, to make the exercise worthwhile. As a result, he calculates that France will by 2012 have an adjusted debt-to-GDP ratio—with debt including the underfunding of its banking system—of 109 percent. By contrast, Egan projects that—since the U.S.'s banks are "only" underfunded by $170 billion (mostly because of Bank of America)—the U.S. will by 2012 have a slightly lower adjusted debt-to-GDP ratio: 105 percent. Unlike S&P, Egan thinks French debt is likely to grow, not shrink, in part because of the high cost of supporting and recapitalizing the French banking system.

Last week, the stock prices of French banks plummeted, with Société Générale , the country's second-largest bank, hitting a new 2.5-year low. Even so, France's banks argue that everything's fine and that any criticism is just unfounded rumor. (Bonjour, Lehman!) Even if they're right, being right doesn't always matter, particularly in tumultuous financial times. The health of any financial institution depends on confidence. There are rumors that U.S. money market funds, which have been a major source of dollar funds for European banks, are pulling back; reports are trickling out that European banks are having funding problems in other countries, too. During the next 24 months, major European banks will need to roll trillions of euros in debt. All this could lead to harmful speculation. "Of course, speculation will always make a crisis worse," Soros told Der Spiegel. "If there is a weak point, it will expose it."

The ramifications of all of this are really unpleasant, because France's sovereign guarantees provide the second-largest contribution (behind Germany's) to the EFSF. The EFSF uses its resulting AAA guarantee to borrow cheaply. If France's rating changes, that will throw the EFSF mechanism for a loop. And if France is downgraded, then French banks probably will have to be downgraded, too. That, in turn, may mean other European banks will be downgraded too. Such cascading downgrades would increase the funding pressures on European banks at a uniquely inopportune moment.

By downgrading the United States, Standard & Poor's has created a dilemma for itself. If there is to be any logical consistency to S&P's ratings, then France can't be AAA when the U.S. isn't AAA. But if France loses its AAA rating, all hell will very likely break loose. S&P can lose whatever credibility it has left, or it can lose whatever friends it has left.

Correction, Aug. 18, 2011: This article originally and incorrectly said that Standard & Poor's and Egan Jones downgraded the United States' crediting rating to AA. (Return to the corrected sentence.) Correction, Aug. 19, 2011: The article also originally stated that Mark Blyth was a professor at Dartmouth. (Return to the corrected sentence.)